Why Active Investing is Back

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Personally, I would argue that stock picking has never left. I began my career with large Wall Street firms finding suitable stock investments for large institutions (mutual funds, hedge funds). Further, the notion of being purposefully selective with investing as the US goes through the ups and downs of an economic cycle always made sense to me. So, I am putting my bias firmly on the table, open kimono, so to say. From here my objective is to lay the groundwork for why I believe active investing or stock picking (these are synonymous to me) makes a lot of sense going forward.

There has been one nearly constant force in place since 2009 helping to propel the US equity market to ever higher levels, our Federal Reserve and their accommodative stance. More specifically, it has been the balance sheet of the Federal Reserve that has expanded from just over $1 Trillion to almost $9 Trillion from 2010 to 2022. Now, the correlation between the Fed’s balance sheet and the S&P 500 may not be one, but it has been pretty high, as you can see in the graph below. It has been a fantastic run in the markets as the Fed has expanded its balance sheet. Now the Fed is raising rates and engaging in quantitative tightening, these efforts are designed to slow growth, decrease inflation and shrink the Fed’s balance sheet. None of the aforementioned is bullish for equities.

In addition to our own Fed, central banks around the world with the exception of Japan and China have also been raising interest rates. In fact, we have seen the fastest and largest rate rise cycle since 1980! As you know, these rate hikes have a lag in terms of their impact on the real economy. As you can see from the chart below almost every spike in interest rates has led to a recession. In my opinion, there is more downside to 2023 earnings estimates that have yet to be reflected in many stocks. We did a webcast back in September talking about the potential for the interest rate bear market giving way to the earnings bear market. For the active manager, this is a welcome change, because individual companies can distinguish themselves from the broad market given their unique fundamentals. Said another way, earnings-led bear markets are much easier to handicap than interest-rate-led ones because you are dealing with fundamentals versus broad multiple compression due to higher costs of capital.

The last phase of the bull market saw seven stocks represent roughly 25% of the S&P 500 and account for roughly 70% of the performance for 2021. That last phase of the bull market benefitted passive/index investors as the S&P 500 is a market cap-weighted index. Now, unfortunately, in my opinion, investors face the inverse scenario. As the liquidity drains so too will these bloated equities. We’ve already seen a lot of weakness in these stocks, I think it continues. Thus these stocks become a huge headwind for the passive investor. The active investor has the opportunity to do their own fundamental analysis and invest in stocks with unique drivers at compelling valuations.

There was a Dutch study of active managers done more than ten years ago and published in IPE magazine in 2011. The study looked at active managers of bond and equity funds in the US and Europe over a 20 year period. One of their findings; “the potential for outperformance of active managers turns out to be higher in markets with many independent investment opportunities and lower in markets with fewer independent investment opportunities.” I think this finding really resonates with the current environment. The Fed’s expanding balance sheet added liquidity to our equity market that found its way into many of the largest components of the S&P 500 and Nasdaq 100. In my opinion, this will work in the opposite direction as the balance sheet contracts. This is probably not good news for the 7 largest components of the S&P 500 but the other 493 can be vetted on their own individual merits, providing many independent investment opportunities. As the Fed’s balance sheet shrinks, correlations throughout capital markets loosen thus providing a backdrop for the active manager to drive alpha. In support, the Dutch study found that 20-40% of managers do show persistent outperformance relative to a portfolio of investable index funds. The trick is to find such a manager and stick with him/her/them.

I believe equity markets face continued headwinds as we enter 2023. The Federal Reserve is on a path to continue the tightening of financial conditions and shrinking of their balance sheet. No one knows how long this process will last or the effect it will have on the broad equity market. What does seem obvious is the incorporation of active equity management in asset allocation where it is lacking. The evidence is there. One might even suggest that the financial advisor examine the situation from a fiduciary perspective. The backdrop that has propelled passive investing to the forefront has shifted, perhaps you should consider shifting too.

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Sincerely,

Frank Grinnell

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Advisory services are offered through Grinnell Capital, LLC, a Utah Investment Advisor.

This information is a general publication that reflects our opinion and is not a specific recommendation to any one individual. You must consult your own broker or investment adviser for investment advice.

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